Pimco: Debt, deficits & inflation

By Kurt Brouwer

In his monthly Investment Outlook, Bill Gross points to the natural outcome of high government deficits and debt. Growing deficits and higher debt lead to weakened creditworthiness, higher interest rates and higher inflation. This is grim news yet he imparts it through a rather whimsical rocking horse metaphor that still has me scratching my head. But, Bill Gross is no stranger to metaphorical excess so let’s not get hung up on that. Instead, let’s go right to the pivotal point of the commentary [emphasis in the original]:

…As a November IMF staff position note aptly pointed out, high fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation, both trends which are bond market unfriendly.

This is a very important point. High deficits and debt lead to higher interest rates and, ultimately, to higher inflation. Throughout the course of economic and financial history, we have seen plenty of evidence for this point. The only counter-argument would be that collapsing economic conditions could lead to deflation and thus to lower interest rates — temporarily. But, Gross is suggesting that higher debt, deficits and inflation are more likely. And, history is on his side.

Pimco continues [emphasis added in bold]:

In the U.S. in addition to the 10% of GDP deficits and a growing stock of outstanding debt, an investor must be concerned with future unfunded entitlement commitments…the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt?…

…The trend promises to get worse, not better. The imminent passage of health care reform represents a continuing litany of entitlement legislation that will add, not subtract, to future deficits and unfunded liabilities. No investment vigilante worth their salt or outrageous annual bonus would dare argue that current legislation is a deficit reducer as asserted by Democrats and in fact the Congressional Budget Office. Common sense alone would suggest that extending health care benefits to 30 million people will cost a lot of money and that it is being “paid for” in the current bill with standard smoke, and all too familiar mirrors that have characterized such entitlement legislation for decades. An article by an ex-CBO director in The New York Times this past Sunday affirms these suspicions. “Fantasy in, fantasy out,” writes Douglas Holtz-Eakin who held the CBO Chair from 2003–2005. Front-end loaded revenues and back-end loaded expenses promote the fiction that a program that will cost $950 billion over the next 10 years actually reduces the deficit by $138 billion. After all the details are analyzed, Mr. Holtz-Eakin’s numbers affirm a vigilante’s suspicion – it will add $562 billion to the deficit over the next decade. Long-term bondholders beware.

Throughout the debate on the recently-passed health insurance reform legislation, there were many claims by supporters that it would ‘reduce’ the deficit. Since passage, that claim is still being made despite obvious evidence to the contrary. Notice how emphatically Gross rejects that claim.

Regardless of the arguments for higher healthcare spending, it should be clear that higher entitlements lead to more debt and higher deficits. Higher inflation is the normal counterpart of higher debt and deficits.

Based on this, I would expect the portfolio duration of Pimco Total Return to come down. We’ll see if that is correct. Another point he made, that I have made before, is that high quality corporates can be more attractive than government debt these days.

Finally, we are in the midst of a transition as we go from an environment in which interest rates trended down for years. Now, we are facing an uphill climb with interest rates. As we get further into this new environment, we will find that successful income investing requires different strategies than before.

About Fundmastery Blog

Kurt Brouwer is a fee-only financial advisor with three decades of experience. He is the chairman and co-founder of Brouwer & Janachowski, LLC. Kurt has written books, articles and hundreds of blog posts on mutual funds, ETFs and other investment topics. E-mail: kurt.brouwer *at* gmail.com.